Product pricing is a strategic process that influences customers’ perception of your offering and ultimately impacts your sales and profitability. It requires businesses to balance various factors, including production costs, profit margins, customer value perception, and the competitive landscape.
Here’s everything you need to know about product pricing, including pricing models, strategies, and how to figure out the best price for your product.
Which pricing strategy should you use?
When making product pricing decisions, companies typically choose a number that will turn a profit and justify production. This is not a hard rule, however, as competitive product pricing often involves offering a low price to attract customers away from the competition.
The right pricing strategy depends on various factors, including your product type, target market, and business goals. Here are some common pricing strategies to consider:
Value-added pricing
This strategy focuses on the perceived value your product offers customers, rather than just the production cost. You set a price based on the benefits and solutions your product delivers. For example, a bakery might use value-added pricing for its artisan bread.
Dynamic pricing
This approach adjusts prices based on real-time market conditions, like consumer demand and competitor pricing. A small coffee shop, for instance, might dynamically price its iced lattes, offering them at a lower price on hot summer days to attract more customers. While dynamic pricing is often effective, it can be complex to implement and might not be suitable for all small businesses.
Cost-plus pricing
This is a simple model where you add a markup percentage to your product's production cost to arrive at a selling price. For example, a small woodworking business might use cost-plus pricing for custom furniture, ensuring they cover material and labor costs while also making a profit.
Competition-based pricing
Also known as competitive pricing, this strategy is about pricing your product based on what similar products are selling for, in conjunction with the state of the market and the perceived value of your product.
An offshoot of competition-based pricing is market share pricing. Though both strategies leverage competitor pricing to set their own rates, market share pricing specifically focuses on maximizing market share by setting a lower price than competitors. For instance, a new grocery store might deliberately set lower prices than national chains to attract customers and gain a foothold in its local market.
[Read more: What Businesses Must Know to Establish an Effective Pricing Strategy Today]
Common pricing models
If your pricing strategy is the "why" behind the price, your pricing model is the "how” — as in, how your customers pay for your product or service.
Some common pricing models include:
- Flat-rate pricing: A single product with a single set of features is offered for a single price. For instance, a gym membership might offer a flat-rate monthly fee for access to all its facilities.
- Pay-as-you-go pricing: Customers are charged based on their usage of a product or service. This is a good option for businesses with unpredictable customer demand. Examples include prepaid phone plans or cloud storage services where you pay based on the amount of storage used.
- Tiered pricing: This model offers multiple packages with different combinations of features at different price points. For instance, software-as-a-service companies often have tiered plans offering different levels of access to specific product features.
- Price per user: This is a common model for software companies, where a fixed monthly or annual fee is charged for each person using the product. This allows businesses to easily scale their revenue and it's more predictable than pay-as-you-go pricing.
- Subscription and membership models: Under a subscription model or membership model, customers pay a recurring fee to access a product or service, often with ongoing benefits or exclusive content. This is a popular model for things like streaming services, where users pay a monthly fee for unlimited access to a library of content, or certain news websites that offer premium content to subscribers.
[Read more: How to Price Your Services]
You will need to give your product time in the market to understand how customers respond to its pricing. Usually, conducting a quarterly review can help you gauge customer interest and satisfaction.
How to calculate product pricing, step by step
1. Add up variable costs per product
Variable costs are directly tied to the product. These costs increase or decrease depending on how many products you make. Raw materials and shipping supplies are both examples of variable costs.
It’s easy to determine a product’s variable baseline cost if you purchase inventory. But, if you make it yourself, your product’s cost is the price of bulk materials divided by the number of items produced.
Next, look at hourly or daily wage, and divide that by the number of items produced in that time. Finally, consider packaging and bonuses. Use unit pricing to calculate the cost of shipping supplies and branded “freebies” (like decals or printed coupons), and add fees determined by your delivery service.
2. Add in your profit margin
A profit margin is the percent of a sale that is profit. For example, if a product with total variable costs of $10 sells for $12.50, its profit margin is 20% (the $2.50 profit is 20% of the sale).
If your goal is a 20% profit margin, you can work backward to determine your pricing using this formula:
Price = (total variable costs) / (1 - 0.20)
If the calculated price is much higher than your average competitors’ pricing, you may need to reconsider your production costs. If your price is low, you may be able to plan for an even higher profit margin.
3. Factor in fixed costs
Fixed costs relate to the functioning of your business and include items like insurance, rent, software licenses and permits, and payroll expenses. Figuring out your total fixed expenses in a given time period will tell you how many sales you need to make to break even.
4. Adjust accordingly
You will need to give your product time in the market to understand how customers respond to its pricing. Usually, conducting a quarterly review can help you gauge customer interest and satisfaction.
If you find sales are lower than needed after a quarter with your product or service set at a particular price, use your industry knowledge to determine if that means pricing up, down, or cutting your own costs.
[Read more: Why Top Brands Are Using These Pricing Strategies to Drive Business in a Challenging Environment]
Best practices for pricing your products
Before you set your final price for a product, it helps to do some research and follow some strategic best practices.
Understand common pricing strategies in your industry
Pricing your product requires background knowledge of your industry. Compare your product to similar ones in the market to determine an average price range. If your product is of higher quality, customers may be willing to pay slightly more. If your product lacks all the bells and whistles, you may be able to compete on price with larger competitors.
Conduct market research
Your customer base is your best guide for what works and what needs to be changed. Market research, whether conducted internally or outsourced to a market research firm, will give you important insights into what your customers want and what your competitors are offering (or lacking). This information will also serve as a foundation for your pricing strategy.
Popular market research techniques include surveys, focus groups, interviews, and conjoint analysis. Small business owners can leverage easy-to-use online survey tools like SurveyMonkey or Google Forms to collect data.
Experiment with pricing
If you’re just starting your business and testing out a minimum viable product, you may have some room to experiment with pricing. To gather the data you need, you will need a large sample size of customers, including customers who are not your usual, repeat buyers. With incremental changes in price within set time windows, you can get real information about what people are willing to pay.
Consider price-testing methods (like A/B testing) to understand customer willingness to pay at different price points. This should ideally be done with a large sample size, including those unfamiliar with your brand. Be open to ongoing experimentation with your pricing. You may need to make adjustments to your goals and work new practices into your production and marketing strategy.
Focus on long-term business profit
Customer lifetime value (CLV) is a measure of the total amount of money a customer is expected to spend on your products during the entirety of an average business relationship. This metric can help you understand customer loyalty. Since loyalty and retention go hand in hand, this metric can clue you into whether customers are coming to you for a deal or really love your product.
If you find yourself constantly discounting your products to keep generating sales, take a hard look at your CLV. You may be targeting the wrong customer group and should adjust your pricing for a different segment.
As your business evolves, keep your customers with you by rewarding their loyalty and offering incentives to keep buying from you. Increasing your CLV while keeping your product or service relevant to a wider market will help keep your company growing for years to come.
Emily Heaslip and Miranda Fraraccio also contributed to this article.
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